Many people get a bit confused when discussing margin and leverage. While the two are closely connected, they are different. Margin is the borrowed money used to invest in financial assets, while leverage refers to the act of taking on debt. This is a subtle, but real difference.
With a margin account you become able to borrow money from your broker with a fixed rate of interest. That borrowed money can then be used to purchase whatever assets the broker might have on offer. The ultimate goal when using margin is to borrow capital at a lower rate of interest and then receive greater returns through your investments.
Margin is used to create leverage.
What is Leverage?
Leverage is what we refer to when borrowed capital is used to increase the potential profits of any investment or trade we make in the financial markets. Of course, leverage does not guarantee profits. A leveraged trade can also go the wrong way, leading to larger losses than would otherwise be the case. Because of this, the use of leverage is always tied to a greater level of risk. It’s important to use risk management techniques when using leverage since leverage can increase both profits and losses.
What is Margin?
Margin is borrowing money from your broker in order to increase your buying power. When margin is available a trader may only need to put up a small portion of their own money as part of an investment. This small portion is called initial margin when opening a trade and it can be as little as 1% or less of the value of the trade.
Margin trading can be beneficial when used properly, however, it also increases the risks inherent in trading because it creates the potential to lose the entire value of your account on one trade. If you are rated as a professional client, you can even lose more than the value of your account and would be required to make additional deposits to cover the shortfall.
The amount of margin for any trade will depend on the broker’s margin rate requirements. This amount is also different for each asset class, so traders will often be able to get greater margin on forex trades than they can on equity trades.
Trading with leverage and margin does increase risk, but can be worth it since it also comes with the following advantages:
Increased Potential Returns – The most important advantage to using margin is the potential to greatly increase the profits made on trades that go in your favour.
Lower Interest Rates – When compared with borrowing money from other sources the interest rates on margin trading are often the most competitive around.
Avoid Cash Account violations caused by unsettled funds – Buying and selling securities and options in a cash account can leave unsettled funds since it typically takes two business days to settle any transactions made. In some cases, this can lead to a Good Faith violation and if this occurs three times, your broker could institute a 90-day Restriction. Using margin will help to avoid these violations.
Trading Flexibility – Being able to open positions with smaller amounts of available capital can allow you to take advantage of more of the opportunities offered by the markets.
Diversification – As mentioned above, the power of margin can allow you to open additional positions in your trading, which in turn can give you greater diversification as your positions won’t be so concentrated.
Easier Financing Option – If your account is already approved for margin, it offers an easy way to finance your needs without the hassle of additional paperwork or borrowing fees.
Margin is a useful and convenient feature, but it doesn’t come without risks. Just as other types of debt come with financing risks, interest payments, and reduced flexibility in future income, margin loans have the same issues. The two largest risks however are leverage risk and the risk of a margin call.
Leverage Risk – Margin can boost your returns, but it can also boost your losses just as dramatically.
Margin Call Risk – When you are trading using margin, your broker will require you to keep a specific percentage of equity in your account. If your equity drops below this, you will be hit with a margin call and will be required to deposit additional funds or face the risk of having your positions closed out by the broker, despite any current losses.